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What is Penny Stock Fraud?

By Damir Wallener
Updated May 16, 2024
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Stocks, or shares, are a type of security that denote ownership in a corporation. The holder of a stock owns a claim to a percentage of the corporation's earnings and assets. Penny stocks are stocks that normally trade for under $1, often for under a penny. They are poorly regulated and penny stock fraud has become so prevalent a colorful vocabulary has sprung up in response.

The most common penny stock fraud is the Pump and Dump. A small group of speculators will accumulate a large number of shares in a penny stock. Once their positions are in place, they will release positive financial porn, news so unexpected and titillating it can drastically affect people's perception of the stock. The intent is to get small-time investors to start trading irrationally. The news is almost always false, but before this is discovered, the price of the stock often skyrockets and the original speculators exit with large profits.

The converse of a Pump and Dump is a penny stock fraud called the Poop and Scoop. Here the manipulators spread highly negative false rumors about a company in order to drive the price down. They buy as the stock plummets, counting on a rebound in price once the rumor is dispelled. In a related fraud, manipulators first short sell stock before releasing the rumors. On the subsequent decline, they cover their positions at a profit.

Another common penny stock fraud is Front Running. In this case, the news is actually true; insiders or brokers, knowing what is coming, take large positions ahead of the news becoming public. If insiders are involved, this is also referred to as insider trading, and is illegal.

When a stock has been laying dormant for a long time, insiders may attempt to increase interest with a type of penny stock fraud known as Circular Trading. Using multiple accounts, often established overseas, they will trade the same shares back and forth between their own accounts to create the appearance of activity. With the assistance of a complicit broker, they may complete Cross Trades, where large blocks of stock are traded without appearing on the exchange records. Once third party interest is generated, one of the schemes described above may be executed.

Collectively, these techniques are referred to as Guilt-Edged Investments. The internet, with its ability to instantaneously spread information, has brought with it an explosion in the number of penny stock frauds. Stock-related chat boards and forums have become ground zero of such schemes, and regulatory agencies such as the SEC have begun monitoring them as a first line of defense.

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Discussion Comments
By anon334971 — On May 17, 2013

Brokers and financial advisors should not be advising large amounts be put into such speculative investments. If they have, there are remedies that can be sought for large losses in some cases, such as in cases of securities fraud, or if the investor was unaware of the risks.

By anon306977 — On Dec 02, 2012

Penny stocks are often speculative. However, this still does not alleviate the duty of those communicating regarding the investment or transactions in such securities to act honestly. Material omissions and misrepresentations in connection with the purchase and sale of securities are actionable. --Daniel B., Securities Fraud Attorney

By anon228892 — On Nov 11, 2011

Nice and quite useful blog. I would like to say that stock market hardly gives any second chance. Once an opportunity is lost, it's gone forever. Now the biggest question is how to grab trading opportunities every time we trade?

Well here's where the technical analysis comes in handy. Just rely on research rather than your gut feeling and stop speculating in the share market.

Follow a few basic trading rules and we are sure one can earn a huge amount in the Indian stock market only by trading in the NSE and BSE.

By Babalaas — On Jun 29, 2010

@ ValleyFiah- The mob has actually been a part of the over-the-counter markets for decades. The OTC markets are where the mob seeped into Wall Street.

In the '90s, mob related microcap fraud really began to pick up. Mob activities in the OTC markets began to pick up mostly due to the business they lost when the feds went after the Mafia involvement in the waste management industry and the Fulton fish market. The mob lost about a half million dollars when they lost their position in these two markets. This was also when the SEC began to actively pursue, and indict on criminal charges, fraudsters in the OTC markets.

Through the '90s and into the early part of this decade, the SEC and the FBI indicted hundreds of mob associates on fraud charges. The mob had become so entrenched in the OTC markets that a sting in 1999 revealed a mob run "pump and dump" network that caused more than $100 in losses on the OTCBB and NASDAQ markets.

The problem of the mob and OTC market manipulation has gotten so bad that in the early part of this decade there were even a few murders of penny-stock analysts and brokers on Wall Street.

By ValleyFiah — On Jun 29, 2010

Most of the "pump and dump" schemes that the SEC has prosecuted are linked to the Mafia. Five families from New York and New Jersey have had associates that the SEC prosecuted for their involvement in securities fraud related to microcap securities.

Many of the companies that the mob was “pumping up” were fictional and never sold a product or a service. A couple examples listed on the SEC website are Lazer Corp, which supposedly sold a self-chilling can, and Transun International Airways. The mob touted Transun as a successful well-funded international airline start-up. After the mob inflated claims about Transun, they dumped $8 million worth of stock on investors who wanted a piece of the airline's success.

By Amphibious54 — On Jun 28, 2010

A chop stock is another type of microcap stock fraud. Chop stocks allow brokerage houses to dump stocks with very little liquidity on the unsuspecting public; all while gaining large profits that do not have to be reported as commissions. The way that brokers sell chop stocks creates a conflict of interest, but chop stocks are still technically legal. The SEC does go after brokers that sell chop stocks through other channels.

Chop stocks are large blocks of illiquid stocks bought from a single investor at a steep discount. The large investor has no knowledge of the scheme, but s/he cannot offload them on the market because there are not enough buyers. The broker then chops the block of stocks and sells them to their unsuspecting clients at market price, claiming that the stocks are going to be winners.

The consumer is then stuck with a stock that is not likely a winner, while the brokerage collects large sums of money that they do not have to report to their buyers. The spread that these brokers gain is technically not a commission.

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